There are tax implications in almost every monetary transaction in a divorce. Whether you are going through a divorce yourself, helping a friend or family member go through a divorce or advising a client through a divorce, it is important to understand how these tax implications will affect the division of assets and future payments. This article will focus on some of the most important tax issues that spouses should be aware of during divorce proceedings.
- Know your tax filing status – Your tax filing status for the entire year is determined by your marital status on December 31 of the year. In the year your divorce is finalized, your filing status for the entire year will either be Single or Head of Household.
- What is Head of Household Status? – An individual who has custody of a child following a divorce will often qualify for Head of Household (HOH) filing status. To qualify for HOH status, a spouse must:
- Be unmarried as of December 31st of the year.
- Maintain a home for at least one unmarried child (or qualifying relative) for at least half of the year, and the home must be the child’s/relative’s principal residence.
- Pay more than half the cost of maintaining the home.
There are two important factors to keep in mind regarding the above rules:
- The qualification for paying more the half the cost of maintaining the home is not the same as paying more than half the cost of supporting the child. Costs for maintaining the home include such things as real estate taxes, mortgage payments, maintenance and providing food on the premises. Such costs, however, do not include direct support for the child such as education, clothing and medical expenses.
- Often times divorce agreements stipulate that the ex-spouses may claim the child as a dependent for tax purposes every other year. A divorced spouse may claim HOH status even if they are not eligible to claim the dependency exemption in a given year as long as the HOH qualifications above are met.
- Understand how marital assets are divided – There are three ways that marital property is divided in a divorce: Alimony, child support and property settlements.
- Alimony – Alimony is tax-deductible by the payor spouse and is included as income by the recipient spouse. The alimony amounts are deductible and included in income regardless of the income levels of each spouse.
- Child support – Child support is not deductible nor included in income by either spouse.
- Property settlement – The division of marital assets in a divorce is almost always tax-free to both parties.
- What payments qualify as alimony? – Alimony is a very common type of payment made between ex-spouses. There are some important things that must be kept in mind when dealing with alimony:
- Whether payments constitute alimony or not are determined by the Internal Revenue Code. A payment may be called “alimony” in a settlement agreement, but if it doesn’t meet the tax code qualifications of alimony, the payments won’t be considered such.
- The terms “spousal support” and “spousal maintenance” are sometimes used in lieu of the term alimony, but they mean the same thing.
- Alimony amounts and duration of payments are controlled by state law, and the laws vary from one state to another.
To qualify as alimony under the Internal Revenue Code, the payments must adhere to the following specifications:
- The payments must be made under a written agreement.
- The spouses must live in separate households.
- The payments must be made in cash or cash equivalent.
- The payments must be made to a former spouse or to a 3rd-party on behalf of the former spouse. If payments are made to a 3rd party, the former spouses must agree in writing to that effect.
- The separation agreement must not state that the payments are not considered alimony.
- The spouses may not file a joint tax return with each other for the year.
- The payments may not continue after the death of the payor spouse.
- Most marital assets can be divided tax-free between spouses – Section 1041 of the Internal Revenue Code (IRC) covers the transfer of assets between spouses in a divorce. IRC 1041 stipulates that marital assets in a divorce are to be divided tax-free to both parties and that if property is transferred after the divorce is finalized, such transfers will be tax-free if the property is transferred:
- Within one year after the divorce is finalized, even if it is not specified in the divorce decree.
- In years 2-6 after the divorce is finalized, but only if it is specified in the divorce decree.
- What should you do with your principal residence? – A couple’s house is often the most valuable marital asset, and there are monetary and non-monetary considerations involved (such as emotional attachment or keeping the house because of children). A divorce does not preclude a spouse from utilizing the home sale exclusion when the property is sold. The qualifications for excluding the gain on the sale of a personal residence can be found in my blog on the topic here.
- The residence is sold during the divorce proceedings and the proceeds are distributed to the spouses.
- Ownership is transferred to one spouse while the other spouse receives other assets to balance the property settlement. One major issue here is that if there is an existing mortgage on the property, the non-owner spouse may demand that the other spouse refinance the mortgage in his or her own name. This may not always feasible for the spouse remaining in the home.
- Sale of the house is delayed until a future year or upon the occurrence of an event, such as the children graduating high school. In this situation the divorce agreement will stipulate how the property will be maintained and how the sale proceeds will be divided.
- The higher-income spouse moves out but pays all of the expenses of maintaining the home, and when the house is sold, the division of the sale proceeds is adjusted accordingly.
- Dividing retirement plans – Retirement plans are often some of the most valuable marital assets. And while such plans can usually be divided tax-free, certain procedures must be followed to ensure a tax-free split of the asset.
- For qualified retirement plans such as pensions, profit sharing plans or 401(k)/403(b) plans, such asset divisions must be specifically divided using a Qualified Domestic Relations Order (QDRO).
- IRAs cannot be divided under a QDRO, but they can be divided tax-free under a divorce or separation agreement.
CAUTION: Unlike a traditional or Roth IRA, the division of inherited IRA will most likely have severe tax consequences for the spouse who inherited the IRA. Spouses need to be very careful in structuring settlement agreements when inherited IRAs are involved.
- Transferring business interests – The transfer of an interest in a business (either stock or a partnership interest) between spouses will not normally trigger any taxable gain or loss to either party. However, tax considerations of a sale of the business by either party down the road should be taken into consideration when structuring a settlement agreement. Often times, a spouse who owns an interest in a business will have a buy/sell agreement in place among the company and fellow business partners. Such agreements should be reviewed for how the business interest is valued because the stated value of the business in a buy/sell agreements usually gets disputed during divorce proceedings.
- State courts cannot control IRS tax matters – Divorce courts are state courts, and state courts have little or no authority in making orders concerning IRS tax matters. Some of the tax issues that a state court cannot legally compel either spouse to do include making one spouse pay all of the outstanding tax on a previously filed joint tax return or compel either spouse to file a return a certain way (i.e. jointly or separately) during divorce proceedings. However, although a state court has no jurisdiction over IRS tax matters, many settlement agreements contain directives relating to how spouse should file their federal tax returns and/or how federal tax liabilities should be paid. And not complying with the separation agreement can bring about many problems. Tax issues should be carefully examined and agreed to by both parties.
The division of a marital home usually takes the format of one of the following paths:
Spouses going through a divorce with significant assets should be represented by qualified legal counsel, and a qualified accountant with divorce experience should also be part of the team as they can tell you the tax consequences of dividing assets both during the divorce and in future years after the divorce is finalized. Divorces can be complicated and the tax implications of dividing marital assets need to be well thought out and planned for – another area of expertise for Minassian CPA.
A lot of media attention has been given to John Oliver (and rightly so) for buying $15 million worth of old medical debt for pennies on the dollar, and then subsequently forgiving all of the debt.Under most circumstances, if you have a debt that has been forgiven, the amount of the forgiven debt is taxable income to you. This is known as Cancellation of Debt (or COD) income. However, there is a provision in the tax code (Section 108(e)(2)) that says if the debt that is forgiven would have given rise to a tax deduction when paid, then there is no COD income to an individual when the debt is forgiven. Since out-of-pocket medical expenses are allowed as a tax deduction, there is no COD income when medical debts are forgiven. And even though a taxpayer’s ability to actually deduct out-of-pocket medical expenses is severely limited based on income levels, the IRS is not taking that into consideration.